Thursday, September 16, 2010

The Mainstream Media in the U.S. has presented two basic approaches to understanding China's real estate bubble:

1. There is no bubble in Chinese real estate, as demand for housing is so vast it will soak up all the tens of millions of flats that have been built in the past decade

2. It is a bubble and it's fueled by the same dynamic as the bubble that expanded and popped in the U.S. and elsewhere: easy credit and speculative lending encouraged by government policy.

Approach Number 1 has little to support it. Recent on-the-ground surveys found half of the flats in Beijing and Shanghai are empty (or the occupants prefer living in the dark, night after night), while reports based on utility accounts found that there are roughly 65 million vacant apartments in China—the bulk of which are presumably held for investment.

Approach Number 2 has some merit but it misses the key drivers in the Chinese housing bubble, and thus is it ultimately misleading.

My wife and I are fortunate to have a network of contacts and friends in China, and thus we learned that as long ago as 2004 the typical two-income middle class household in China—those in which wage earners make around $5,000 or more a year each—was buying one, two or even three flats for investment purposes.

The apartments were not rented out, as this lowered the resale value, and renting out flats was a burden busy people didn't care to shoulder. Since there is no property tax in China that is analogous to U.S. parcel taxes, and since the vast majority of buyers paid cash, then the carrying costs for these investment properties was very modest. (The equivalent of maintenance/condo fees in most of China are typically well under $100 per month).

Why are Chinese dumping the majority of their savings in housing? One reason is that there are precious few investment options, and many investors felt burned by the volatile Chinese stock market (they are not allowed to invest in overseas funds). Real estate has two advantages over stocks: everyone understands it has value as shelter, and housing has been rising far faster than China's not-quite-benign rate of inflation.

The return offered on bank deposits in China is lower than the rate of inflation, and that creates yet another incentive to put one's money in real estate.

Another factor is what might be called the Central Party Put: many Chinese believe their central government will not let real estate decline. Whether that faith is misplaced or not, only time will tell, but the key is actually held by local government, not the central government-controlled banks.

Imagine that your local city and county controlled all land rights, and the only ownership a private builder or developer could secure was a long-term lease. Now imagine that 40% of the city and county's revenues come from the lease fees paid by developers. Next, imagine a giant real estate bubble has priced most residents out of the market, and that the local governments are reaping huge gains as the development rights and lease they sell are skyrocketing.

That is the very definition of "conflict of interest."

That is the Chinese real estate dynamic in a nutshell: local governments have every incentive to push lease prices higher, further fueling China's real estate bubble, and zero incentive to build low-cost housing for the average citizen.

Minxin Pei, professor of government at Claremont McKenna College and a senior associate at the Carnegie Endowment for International Peace, recently described who benefits from what he termed China’s "irrationally exuberant" property market: local government and its officials, and state-owned enterprises (SEOs) which have exploited their ties to government-controlled banks to enter the speculative real estate market with a vengeance.

"With access to almost unlimited no-cost credit from the state-controlled banking system," he wrote, "these behemoths have abused their financial clout and plunged headlong into the real estate market, snapping up high-priced land and investing in high-end residential housing units that now sit empty across the country."

Once you understand this dynamic, it's not difficult to see why China's housing bubble will end badly. Local governments are so heavily dependent on development fees and taxes for their revenues that any fallback in new development will spell catastrophe for city and regional government budgets.

Sound familiar?

Residents will suffer because government services will have to be slashed as revenues from development fees collapse.

The Chinese investors who overpaid for grossly inflated luxury condos will suffer massive losses, developers dependent on a fast-rising bubble market will go bust, and somebody will end up covering the losses as bankrupt developers renege on their loans.

Since most of the loans came from government-owned banks, then that "somebody" will be the Chinese taxpayer.

Sound familiar?

"China’s taxpayers will twice be made the victims by the housing bubble," Professor Pei noted. "In the bubble years, they are priced out of the market for affordable housing. When the bubble bursts, they’ll pay for the clean-up. When Chinese state-owned banks write off their bad loans, they don’t do so with money growing on trees. Instead, the Ministry of Finance will issue bonds to recapitalize the banks--and fund the bail-out with future tax receipts."

Recent reports estimate there are 64.5 million vacant "investment" flats in China. Analyst Andy Xie recently laid out the risks this giant speculative bubble poses to China's local governments and banks.

"Local governments in China depend on real-estate deals for revenue and could default if the market falls too far," he wrote. "Notice the bind China is in. It has to keep the bubble going to preserve local government finances. They’ve become a classic Minsky Ponzi unit."

If the Chinese central government keeps the bubble inflated with easy money, Xie concluded, the resulting crash and bail-out will only be that much more painful.

While contributions from property developers tend to wield outsized political influence in much of the world, local government officials in China are brazenly pocketing the proceeds from development. For example, the majority of homes in a newly launched subsidized housing project in Shaanxi Province have been handed to local government officials.

Add these factors up--widespread corruption, a real estate bubble that's priced ] average citizens out of the market, local governments dependent on new development for their revenues and a government-run banking sector which will turn to taxpayers to fund the inevitable bail-out--and there is plentiful fuel for taxpayer resentment and anger once the bubble pops.

Based on the accounts provided by these analysts, Chinese taxpayers will soon have common ground with their American counterparts: they'll be stuck paying for the bail-out of private developers and government–controlled banks (which in the U.S. are called Fannie Mae and Freddie Mac).

They'll also share another plight--an imploding economy that was precariously dependent on ballooning debt, financial speculation, officially sanctioned embezzlement and a society-wide magical belief that "real estate never goes down."

I am slowly catching up on correspondence after 15 days away from my desk --your patience is appreciated.

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